As a result of current economic conditions many plan sponsors are facing partial terminations of their 401(k) plans.

Neither the Code nor the regulations explicitly define the term "partial termination".  The information summarized below is an interpretation using information provided by IRS rulings and case law.  Unclear guidance on this issue makes the determination of whether a partial termination has occurred problematic for plan sponsors.  

What is a partial termination?

A partial termination exists if a significant reduction in plan participation occurs as a result of employer initiated severances from employment.  As a general rule, a 20% reduction is considered significant.

What are the effects of a partial termination?

When a partial termination occurs, all participants terminated by the employer in connection with the partial termination must be treated as fully vested in the employer contributions.  If a partial termination occurs and the plan sponsor does not vest affected employees, the plan will cease to be qualified under the Code.  The effects of such disqualification are as follows:

• For open tax years, the employer loses its deduction for nonvested contributions made to the plan
• For open tax years, participants recognize income with respect to their vested accrued benefits
• For open tax years, the plan’s trust recognizes income on earnings
• Distributions from the plan are not eligible for rollover into another tax-qualified plan
• The plan sponsor and/or plan fiduciaries responsible for failing to maintain the plan’s tax-qualified status face the risk of lawsuits by participants who are forced to prematurely recognize income

How is the significant reduction calculated?

In applying the partial termination rules, the IRS aggregates all employer initiated terminations during a rolling two year period unless the employer can establish the terminations were unrelated.  Additionally, it is not clear how participants with no account balances should be considered.  The only court that has explicitly addressed this issue determined that they could be excluded, but the case was ultimately decided on other grounds.  The most recent partial termination analysis from a US Court of Appeals suggests that participants with no account balances would be included, but it did not specifically address this.  

If you have questions regarding this issue or how it could affect your plan, please contact Karyn Lowrey, Partner, at 678-741-2541 or klowrey@bspj.com.